Weighted Average Cost of Capital

WACC is a very important cost figure for any company (Pratt et al. 2014). It is defined as where:

D = debt (long-term loans, corporate bonds, etc.) (dollars)

E = equity (stocks) (dollars) t = corporate tax rate (percent)

V = E + D (dollars)

Ke = cost of equity capital (e.g., 0.15-0.18)

Kd = cost of debt capital (e.g., 0.08 = yield to maturity [YTM] rate for bonds, plus cost associated with lost growth opportunity)

In general, an increase in leverage (e.g., adding more debts) reduces the firm's WACC. This is due to the tax deductibility of interest payments associated with the debt. For many companies, WACC is typically in the range of 8%-16%.

Effect of Financial Leverage

Financial leverage denotes the use of debts in financing corporate projects. A measure of financial leverage is given by the leverage ratio D/V The company is said to be highly leveraged if its leverage ratio is more than 0.5 (Mathis 2014).

Leverage ratio is known to have an impact on both the variability of reportable earning per share and the return on equity values. This is illustrated by the following example.

Assume that the total assets of a company are $1000. These assets may be financed 100% by equity (Case A) or by a combination of 40% equity and 60% debt (Case B). It is further assumed that under normal circumstances the company's EBIT is $240. The EBIT value may be reduced to $60 under bad economic conditions, but it could be increased to $400 under good conditions. The corporate tax rate is assumed to be 50%. There is no interest payment in Case A. However, $48 must be paid in Case B as an interest charge, which is tax deductible. The net incomes in these cases are different. The earning per share and return on equity data reported out by the company vary accordingly (see Table 7.12).

Under normal economic conditions, the earning per share is 1.20 in Case A (no debt) and 2.40 in Case B (with debt). Thus, companies engaged in debt financing will be able to report out higher earnings per share data than others that carry no debt, assuming everything else being equal.

In the absence of leverage (no debt, Case A), the earning per share varies from 0.3 to 2.0 and the return on equity from 3.0 to 20 (both from 25% to 167%). When the company engages in debt financing, these same ratios vary more widely from 0.15 to 4.40 and from

1.5 to 44.0 (both from 6.25% to 183%), respectively. Financial leverage compounds the variability of companies' financial performance.

TABLE 7.12

Impact of Leverage on EPS and ROE

Case A

Case B

Bad

Normal

Good

Bad

Normal

Good

Assets

1000

1000

Debt

0

600

Equity

1000

400

Leverage ratio (%)

0

60

EBIT

60

240

400

60

240

400

Interest (8%)

0

0

0

48

48

48

Taxable income

60

240

400

12

192

352

Tax (50%)

30

120

200

6

96

176

Net income

30

120

200

6

96

176

Number of shares

100

100

100

40

40

40

EPS

0.3

1.2

2

0.15

2.4

4.4

ROE (%)

3

12

20

1.5

24

44

Notes: When ROE exceeds interest (cost of debt), leverage has a favorable impact on EPS, and vice versa. Financial leverage increases the variability of EPS positively as well as negatively.

FIGURE 7.2

Optimum leverage.

 
Source
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